Inflation Risk andP-C Insurance:

Overview and OutlookJoint Meeting of the Underwriting, Claims,

and Emerging Issues CommitteesReinsurance Association of America

May 18, 2010 Philadelphia, PASteven N. Weisbart, Ph.D., CLU, Senior Vice President & Chief EconomistInsurance Information Institute 110 William Street New York, NY 10038Office: 212.346.5540 Cell: (917) 494-5945 stevenw@iii.org www.iii.org

2

Presentation Outline

1. What Causes Inflation?

2. Inflation’s Past and Future

3. Inflation’s Effect on Property-Casualty Insurance Claims

4. P-C Premium Growth and Inflation

5. Underwriting and Inflation

6. Investments and Inflation

7. Inflation, Reserve Adequacy, and Impairment

Q&A

3

What Causes Inflation?

What Makes Prices Increase?

An increase in the prices of the components (e.g., materials and labor) of the things we buy, if the sellers of those things pass along their increased costs to buyers

Scarcity of supply in relation to demand. If there isn’t enough of a good or service to meet demand, the price of that item will tend to rise (and some buyers will drop out, creating a supply/demand equilibrium at a higher price)

Expectations. If sellers expect their costs to rise in the near future, they might raise prices now to avoid being caught. This includes the category of “bubbles.”

What Makes the Prices of Items orComponents from Overseas Rise?

A drop in the value of the U.S. dollar. The price of any component that we buy from overseas could rise for us if the U.S. dollar’s value drops in relation to the value of the seller’s currency. In effect, it takes more U.S. money to convert to the same price in foreign currency.

70

75

80

85

90

95

100

105

110

115

Jan00

Jan01

Jan02

Jan03

Jan04

Jan05

Jan06

Jan07

Jan08

Jan09

Jan10

Trade-Index-Weighted US Dollar Exchange Rate*

*The broad index is a weighted average of the foreign exchange values of the U.S. dollar against the currencies of a large group of major U.S. trading partners. The index weights, which change over time, are derived from U.S. export shares and from U.S. and foreign import shares. Sources: US Federal Reserve, Board of Governors, at http://www.federalreserve.gov/releases/g5/current/ ; Insurance Information Institute.

Except in Times of Global Financial Crisis,The U.S. Dollar Has Weakened vs. Other Currencies

January 2000 through April 2010

Depreciation of dollar after Tech bubble

and post 9-11

Post-crisis depreciation of

dollarDollar appreciates in its role

as the global “reserve currency” is affirmed during

the global financial crisis

What Makes the Prices of Items orComponents from Overseas Rise?

New taxes, tariffs, or other charges (e.g., shipping) that increase the effective price of an item.

An increase in the price of the item in the selling country.

Inflation Rates for Largest European Economies & Euro Area, 2010F-2011F

1.3% 1.1%

2.6%

1.5%1.1%

1.6% 1.5%1.8% 1.6% 1.5%

0%

3%

6%

9%

Euro Area Germany UK France Netherlands

2010F 2011F

Source: Blue Chip Economic Indicators, 5/10/10 edition.

% Change from Prior Year

Annual inflation is below 2% across

most major European economies

Inflation Rates for MajorEmerging Economies, 2010F-2011F

2.8%

9.2%

5.0%

7.2%

5.0%

2.9%3.3%

6.6%

4.7%

7.4%

4.2%

3.1%

0.0%

2.5%

5.0%

7.5%

10.0%

China India Brazil Russia Mexico S. Korea

2010F 2010F

Source: Blue Chip Economic Indicators, 5/10/10 edition.

% Change from Prior Year

Annual inflation is forecast to be above 3% across most major countries from which

we import

“Headline” Inflation Rates,* Emergingvs. Advanced Economies, 2002-2009

-2%

0%

2%

4%

6%

8%

10%

Jan

02

Jul 0

2

Jan

03

Jul 0

3

Jan

04

Jul 0

4

Jan

05

Jul 0

5

Jan

06

Jul 0

6

Jan

07

Jul 0

7

Jan

08

Jul 0

8

Jan

09

Jul 0

9

Advanced Economies Emerging Economies

*12-month change in consumer price index, monthlySource: International Monetary Fund, “World Economic Outlook” update January 2010

Japan is an Inflation ExceptionAmong Advanced Economies

Source : Ecowin & SCOR (2010)

196

201

206

211

216

221

déc

-06

févr

-07

avr

-07

juin

-07

aoû

t-0

7

oct

-07

déc

-07

févr

-08

avr

-08

juin

-08

aoû

t-0

8

oct

-08

déc

-08

févr

-09

avr

-09

juin

-09

aoû

t-0

9

oct

-09

déc

-09

99

101

103

105

107

109

111

113

115United States, Consumer Prices, All items, SA, Index,USD, 1982-1984=100Euro Zone, Consumer Prices, All Items, Total (ECB),SA, Index, EUR, 2005=100United Kingdom, Consumer Prices, By Commodity, Allitems (CPI), Index, GBP, 2005=100Japan, Consumer Prices, Nationwide, All Items,General, SA, Index, JPY, 2005=100

Now, Really, What Causes Inflation?

“Too much money chasing too few goods.” When the Federal Reserve and the “shadow” banking system provide more money than people need at current prices, prices rise to absorb the extra money. “Inflation is everywhere and always a

monetary phenomenon.” (Milton Friedman)

Inflation and the U.S. Monetary Base Have Roughly Moved Together (1975-2007)

-3%

0%

3%

6%

9%

12%

15%

18%

75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

CPI-U % change in monetary base

Sources: http://www.federalreserve.gov/releases/H3/hist/h3hist4.txt Insurance Information Institute (calculations).

% Change from Start to End of Year

The Monetary Base is coins, paper, and bank reserves—

money available for use.

17

But the U.S. Monetary Base Exploded in 2008 (Monthly, 1990–2010*)

*As of end of April 2010; seasonally adjustedNote: Recessions indicated by gray shaded columns.

Sources: http://www.federalreserve.gov/releases/H3/hist/h3hist4.txt National Bureau of Economic Research (recession dates); Insurance Information Institutes.

Billions

$250

$500

$750

$1,000

$1,250

$1,500

$1,750

$2,000

$2,250

'90 '93 '96 '99 '03 '06 '09

The 12-month increase, from mid-Sept 2008 to mid-

Sept 2009, was 108.5%.

The subsequent 6-month increase,

from mid-Sept 2009 to mid-March 2010,

was 16.7%.

What Does the Spike in the Monetary Base in 2008-09 Mean for Future Inflation?

-10%0%

10%20%30%40%50%60%70%80%90%

100%110%

75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

CPI-U % change in monetary base

Source: US Department of Labor, Bureau of Labor Statistics

So far, this hasn’t produced rampant inflation because banks have been reluctant to lend (and businesses reluctant to borrow).

But this could change at any time.

In 2008, Central Banks in Europe, the UK, andthe US Dramatically Expanded the Money Supply

Source : Ecowin

0

500000

1000000

1500000

2000000

2500000

300000026

/05/

2006

26/0

8/20

06

26/1

1/20

06

26/0

2/20

07

26/0

5/20

07

26/0

8/20

07

26/1

1/20

07

26/0

2/20

08

26/0

5/20

08

26/0

8/20

08

26/1

1/20

08

26/0

2/20

09

26/0

5/20

09

26/0

8/20

09

26/1

1/20

09

Mo

illio

ns

of

Do

llars

or

Eu

ros

0

50000

100000

150000

200000

250000

300000US Federal reserve Banks, Total assets or liabilities, dollars

Euro Zone, Eurosystem, Total assets or liabilities, EUR

United Kingdom, Bank of England, assets, GBP

-6%

-3%

0%

3%

6%

9%

12%

15%

2004:Q

1

2004:Q

2

2004:Q

3

2004:Q

4

2005:Q

1

2005:Q

2

2005:Q

3

2005:Q

4

2006:Q

1

2006:Q

2

2006:Q

3

2006:Q

4

2007:Q

1

2007:Q

2

2007:Q

3

2007:Q

4

2008:Q

1

2008:Q

2

2008:Q

3

2008:Q

4

2009:Q

1

2009:Q

2

2009:Q

3

2009:Q

4

Home Mortgage Consumer CreditBusiness Corporate

Households and Businesses Are Now “Deleveraging”: Low Inflation Pressure

Source: Federal Reserve Board, at http://www.federalreserve.gov/releases/z1/Current/z1r-2.pdf (latest data as of 5/14/2010)

Percent Change in Debt Held(Quarterly since 2004 at Annualized Rate)

66%

68%

70%

72%

74%

76%

78%

80%

82%

Mar 01

Jun 0

1

Sep 0

1

Dec 0

1

Mar 02

Jun 0

2

Sep 0

2

Dec 0

2

Mar 03

Jun 0

3

Sep 0

3

Dec 0

3

Mar 04

Jun 0

4

Sep 0

4

Dec 0

4

Mar 05

Jun 0

5

Sep 0

5

Dec 0

5

Mar 06

Jun 0

6

Sep 0

6

Dec 0

6

Mar 07

Jun 0

7

Sep 0

7

Dec 0

7

Mar 08

Jun 0

8

Sep 0

8

Dec 0

8

Mar 09

Jun 0

9

Sep 0

9

Dec 0

9

Mar 10

Conventional Wisdom: Inflation Won’t Threaten Until We’re At Full Capacity

Source: Federal Reserve Board statistical releases at http://www.federalreserve.gov/releases/g17/Current/default.htm 21

Recession began December 2007

Percent of Manufacturing Capacity

Hurricane Katrina

March 2001-November 2001

recession

“Full Capacity”

The closer the economy is to operating at “full

capacity,” the greater the inflationary pressure

But Some Industrial ProductionCapacity Has Vanished

Source: Wall Street Journal, Feb. 3, 2009

Some unused capacity is gone, and in other industries new capacity is needed, so the economy might be closer to full capacity than the industrial production numbers indicate.

If so, this might spur inflation sooner than expected.

23

Inflation’s Past and Future

Inflation Isn’t Double-Digit Now as It Was in 1974-81

-2%

0%

2%

4%

6%

8%

10%

12%

14%

70

71

72

73

74

75

76

77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

98

99 00

01

02

03

04

05

06

07

08

09

10F

Sources: US Department of Labor, Bureau of Labor Statistics; Blue Chip Economic Indicators (5/2010 issue) (2010 forecast)

If you started work in the insurance industry 27 years ago, you never experienced

annual inflation as high as 6%

Annual Inflation Rates (%)

25

A Closer Look: Annual Inflation Rates(CPI-U, %), 1990–2014F

2.92.3

1.62.2

3.42.8

1.6

2.32.7

3.4 3.22.8

3.8

-0.4

2.0 1.92.3 2.4 2.4

5.4

4.2

3.0 3.02.6 2.8

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

90

91

92

93

94

95

96

97

98

99

00

01

02

03

04

05

06

07

08

09

10F

11F

12F

13F

14F

Sources: US Bureau of Labor Statistics; Blue Chip Economic Indicators, 3/2010 and 5/2010 issues (forecasts).

The Annual Inflation Rate (CPI-U) Has Been Below 4% Since 1992. The Compound Average Growth Rate of Inflation 1992-2009 was about 2.3%.

Annual Inflation Rates (%)

The recession and the collapse of commodity prices appear to have reduced inflation, at least for nowTwo years after the last

recession ended, prices started up again

26

Forecasts of Yearly U.S. Inflation Rates(CPI-U, %), 2010–2015F

2.0 1.9

2.3 2.4 2.4 2.5

1.7

1.1

1.5 1.6 1.7 1.8

3.23.13.13.12.8

2.4

0

1

2

3

4

2010 2011 2012 2013 2014 2015

Blue Chip AvgPessimistic

Blue ChipMedian

Blue Chip AvgOptimistic

Source: Blue Chip Economic Indicators Mar. 2010 and May 2010 issues.

Overall Inflation Is Forecast to Rise Modestly through 2015but Is Not Expected to Become a Major Concern

Annual Inflation Rates (%)

Even the pessimistic forecasts don’t see the CPI rising much above 3% in the next 5+ years

But Some Economists Say the Fed’s Inflation Target Should be Higher

Headline in Wall Street Journal Monday February 22, 2010:

Low Inflation Always Best? Some Urge a Policy Rethink

Higher inflation brings higher interest rates, giving the Federal Reserve “more room” to lower rates when it wants to stimulate the economy.

Higher inflation also lessens the debt burden (inflation pushes incomes up but debt payments are fixed)

Proposed inflation target: 4% (Current target: 2%)

Bernanke’s Recent Views onthe Fed’s 2% Inflation Target

A major inflation driver is expectations regarding the future rate of inflation Firms will raise prices if they expect their costs to

increase Workers will demand pay raises to offset expected

higher inflation Bernanke’s worry: If the Fed changes its target to a

higher inflation level, people might think that the Fed isn’t serious about inflation, and might bid prices up proactively

Bernanke: the Fed should maintain its 2% target in order to support current beliefs that the Fed will act to limit inflation to 2%

Source: http://www.federalreserve.gov/newsevents/speech/bernanke20100103a.htm

29

So If Inflation Isn’t Threatening Now,Why Are We Worried About It?

Rising Claim SeveritiesCost of claims settlement rises across the board (property and

liability)

Rate InadequacyRates inadequate due to low trend assumptions arising from use of

historical data

Reserve InadequacyReserves may develop adversely and become inadequate

(deficient)

Burn Through on RetentionsRetentions, deductibles burned through more quickly

Reinsurance Penetration/ExhaustionHigher costs risks burn through their retentions more quickly,

tapping into reinsurance more quickly and potentially exhausting their reinsurance more quickly

30

Inflation’s Effect on Property-Casualty Insurance Claims

P-C Claim Severity Generally Has Risen Faster than the CPI

Resurgent Inflation Would Shift ClaimSeverity Upward for any Given Distribution

Source : SCOR

Loss distribution

Loss size ($)

Lo

ss

pro

ba

bili

ty (

%)

Claims before inflation resurgence

Claims after inflation resurgence

Source: Philippe Trainar, “Inflation risk: a long term Pressure scenario for insurance companies,” presentation at the Geneva Association’s Amsterdam Circle of Chief Economists, February 11, 2010.

32

Major Components of the CPI-U,by Weighting

42.0%

16.7%

14.8%

6.5%

6.4%

6.4% 3.7%3.5%

Source: BLS News Release, March. 18, 2010 “Consumer Price Index – February 2010”

P-C Insurance Doesn’t Pay for the Major Items in the CPI. It FactorsSlightly in Housing, Transportation; Significantly in Medical Care

Housing

Other

Transportation

Food & Beverages

Medical Care

Education & Communication

Recreation

Apparel

Nearly 2/3 of this is the rent homeowners pay to themselves for

living in their own home

Inside the Jan. & Feb. 2010 CPI:*Components Move Differently

*seasonally adjusted.Source: BLS

2.6%1.6%

0.4%

-0.2%

3.5%

19.1%

2.1%1.3%

0.3%

-0.1%

3.6%

14.4%

-2%

0%2%

4%

6%8%

10%12%

14%

16%18%

20%

Overall CPI "Core" CPI Owners'Equivalent

Rent

Food &Beverages

Medical Care Energy

Percent change fromsame month, prior year

The “Core” CPI Excludes Price Changes for Food and Energy, Which Are Generally Volatile. These Items Are Nearly ¼ of the CPI. The Largest Single CPI Component isan Estimate of What Homeowners Would Pay as Rent to Themselves as Landlords.

34

Weights of Selected CPI Components Owners’ Equivalent Rent 25.2%Food and Beverages 14.8%Energy 8.6%Medical Care 6.5%

When Prices for Some Items Drop, Check the Prior-Year Surge

Sources: Bureau of Labor Statistics; Insurance Information Institute.

3.8%2.3%

6.8%

10.3% 9.7%

-0.40%

1.7%

4.8%

-2.9%

-4.6%-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

Overall CPI "Core" CPI HeatingEquipment

StructuralSteel

Products

ResidentialMaint &Repair

2008 2009(Percent)

Some Costs Related to Construction Spiked in 2008,Far Above the Overall Inflation Rate (CPI), then Retreated in 2009

35

Price Indexes for Elements ofProperty Claims Monthly, Jan 2008-Feb 2010

185.

5

186.

6

190.

1

193.

0

205.

0

206.

1

200.

4

194.

3

189.

5

189.

9

187.

4

186.

3

186.

3

187.

6

188.

9

187.

9 189.

9

189.

5

188.

8

189.

8

190.

2 192.

619

2.7

205.

4

201.

1

197.

4

180

185

190

195

200

205

210

Jan

08

Feb

08

Mar

08

Ap

r 08

May 0

8

Ju

n 0

8

Ju

l 08

Au

g 0

8

Sep

08

Oct 08

No

v 0

8

Dec 0

8

Jan

09

Feb

09

Mar

09

Ap

r 09

May 0

9

Ju

n 0

9

Ju

l 09

Au

g 0

9

Sep

09

Oct 09

No

v 0

9

Dec 0

9

Jan

10

Feb

10

Sources: Bureau of Labor Statistics; Insurance Information Institute calculations.

Price Index

Construction materials prices spiked through the first half of 2008, returned to pre-spike levels by Spring 2009, but prices for construction materials are

climbing again.

Up 10.7% Jan-July

2008

36

Material and Supply Inputs to Construction Industries

Annual price increases,2008 over 2007: +8.2%2009 over 2008: -3.9%

Up 3.4% Mar 2009-Feb 2010

Inflation in Legal and Auto Repair Costs Affects P/C Claims More than the CPI Suggests

Sources: BLS; Legal services and motor vehicle body work are avg. monthly year-over-year change from BLS;Tort costs is 2009 Towers-Perrin estimate.

-0.4%

1.8%

2.7%3.0%

4.1%3.8% 3.9%

-1%

0%

1%

2%

3%

4%

5%

Overall CPI "Core" CPI LegalServices

US TortCosts

MotorVehicleParts &

Equipment

MotorVehicle

Body Work

MotorVehicleRepair

(Percent)

Repair Parts/Labor and Legal/Tort CostsAre Major P/C Insurance Cost Drivers.

37

In the UK, the Household Rebuilding CostIndex is Also Higher Than the British CPI

Source : Association of British Insurers

Annual Change in the Household Rebuilding Cost Index and Retail Prices Index

0,00

1,00

2,00

3,00

4,00

5,00

6,00

7,00

8,00

9,00

10,00

janv-9

8

avr-

98

juil-

98

oct

-98

janv-9

9

avr-

99

juil-

99

oct

-99

janv-0

0

avr-

00

juil-

00

oct

-00

janv-0

1

avr-

01

juil-

01

oct

-01

janv-0

2

avr-

02

juil-

02

oct

-02

janv-0

3

avr-

03

juil-

03

oct

-03

janv-0

4

avr-

04

juil-

04

oct

-04

janv-0

5

avr-

05

juil-

05

oct

-05

janv-0

6

avr-

06

juil-

06

oct

-06

janv-0

7

avr-

07

juil-

07

oct

-07

janv-0

8

avr-

08

juil-

08

oct

-08

janv-0

9

Annual In

crease

(%

)

HRCI RPI

Household Rebuilding Cost Index

British CPI

All Segments of French Motor Insurance CostsHave Grown Faster than the CPI for Over 20 Years

Source : Fédération Française des Sociétés d’Assurance

Average cost of motor insurance

100

120

140

160

180

200

220

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

100

= 1

987

Liability for materials

Theft & FireGlass breakage

Accidental damagesCPI

Most segments of French home insurance costs have been growing more rapidly than the CPI for more than 20 years

Source : Fédération Française des Sociétés d’Assurance

Average cost of home insurance ("multirisque habitation")

50

100

150

200

250

300

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

FireWind, Snow, HailTheftWater damagesLiabilityGlass breakageCPI

Of Course, The Prices of Some ThingsP-C Insurers Pay For Have Dropped

80

90

100

110

120

Dec

03

Dec

04

Dec

05

Dec

06

Dec

07

Dec

08

Dec

09

Plywood & Engineered Wood

Source: Department of Labor (Bureau of Labor Statistics); not seasonally adjusted

Index Price Change from Prior Year2004 7.0%2005 -1.7%2006 -5.3%2007 -5.0%2008 1.3%2009 -5.4%

42

Inflation’s Effect is Unusually Strong with Health Care Costs

This Isn’t Just a U.S. Phenomenon

Medical Cost Inflation Has Outpaced Overall Inflation for Many Years

80

140

200

260

320

380

82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

Inde

x V

alue

(198

2-84

=100

)

All Items Medical Care

Source: Department of Labor (Bureau of Labor Statistics); not seasonally adjustedhttp://www.bls.gov/news.release/pdf/cpi.pdf

Since 1982-84, (index =100) the cost of medical care has more than tripled, while the overall cost of living merely doubled

French Health Insurance Tells the Same Story (as Does Many Other Countries)

Source : INSEE

100

105

110

115

120

125

130

135

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

100

= 1

998

CPI

Health Insurance CPI

P-C Claims Tend to Be for Intense Medical Activities,Whose Costs Grew Faster than Medical Care in General

100

120

140

160

180

200

220

97 98 99 00 01 02 03 04 05 06 07 08 09

Hospital Services Medical Care

Source: Department of Labor (Bureau of Labor Statistics); not seasonally adjusted; medical care costs re-indexed to 100 in 1997 by III calculations

From 1997 to 2009, hospital services costs grew 107% while the cost of medical care overall grew 60%.

Index

In France, since 2001 a growing gap between the growth rateof the cost of severe injuries and inflation/GDP growth rate

Source : SCOR Global Life (2009)

Average cost of severe French bodily injuries

100

110

120

130

140

150

160

170

180

2001 2002 2003 2004 2005 2006 2007

100

= C

ost

in

200

1

Average costsInflationGDP at current prices

The Rising Cost of Medical Care AffectsP/C Claims More than 2009 CPI Implies

Sources: BLS; medical care changes are avg. monthly year-over-year change from BLS; BI and no-fault figures from ISO Fast Track data for 4 quarters ending 09:Q3. WC figure is I.I.I. estimate based on historical NCCI data.

-0.4%

1.8%

3.1%

4.3%

5.5%6.2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

Overall CPI "Core" CPI Medical Care PP AutoBodily Injury

Severity

WC MedSeverity

PP Auto No-Fault Claim

Severity

(Percent)

Healthcare Costs Are Major P/C Insurance Cost Drivers.They Are Expected to Increase Above the Inflation Rate (CPI) Indefinitely

47

The “core” = the overall CPI after removing the effect of price changes in food and energy

Shifting Legal Liability & Tort Environment

48

Tort Costs Might Spike Again; but This Isn’t the Conventional Sense

of Inflation

The Frequency of Million-Dollar Verdicts*Was Increasing With Moderate Inflation

29%

37%

48%

59%

33%

51% 57

%

65%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Business Negligence Government Negligence Medical Malpractice Products Liability

2001-2003 2004-2005 2006-2007

*Verdicts of $1 million or more.Source: Jury Verdict Research; Insurance Information Institute.

Across all liability types, million-dollar-plus awards rose from 13% of all awards from

2001-2003 to 17% in 2006-07.

In the 1990s and Since 2003, Tort SystemCost Growth Has Moderated vs. Inflation

-6%

-3%

0%

3%

6%

9%

12%

15%

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Rate of Tort System Cost GrowthCPI

Sources: US Bureau of Labor Statistics, Tillinghast-Towers Perrin, 2009 Update on U.S. Tort Costs; Insurance Info. Inst.

Without these two high-growth years, tort cost

growth this decade would have been close

to the CPI

Growth Rate

51

So P-C Insurance Claim Costs Increase Faster Than Inflation.

But Why?

7 Reasons Why P-C Insurance Claims Often Rise Faster than Inflation

1. They contain at least an element of moral hazard, if not also a fraud/abuse dimension that isn’t present in prices generally.

a. This is reinforced by “bad faith” laws and/or consumer attitudes (surveys show that many people believe that it’s okay to inflate an insurance claim). So to avoid “bad faith” outcomes insurers pay some claims they might otherwise challenge

2. When deductibles apply, they tend to stay fixed (in dollars) over long periods of time, even though the price of the insured item increases (so that a larger percent of the damage is covered as time goes on)

Why P-C Insurance ClaimsOften Rise Faster than Inflation (cont’d)

3. P-C insurance sometimes pays for open-ended items (e.g., additional living expenses, liability defense costs) which can, through the quantity of the item purchased, inflate the insurer’s claims spending.

4. For claims that involve health care of severely-injured people, the cost of hospital services has far outstripped the CPI

Why P-C Insurance ClaimsOften Rise Faster than Inflation (cont’d)

5. In some cases, competitive price forces don’t operate as strongly on insured goods and services (vs. non-insured goods and services); for example, they might

a. Be protected from international competition You can’t outsource repair of a car or a building to a

lower-labor-cost country

b. Be affected by the changing social value of life & suffering

The cost of pain medication for people with chronic pain is far outstripping general inflation

c. Concern services where productivity gains are limited

Examples are defending lawsuits, repairing roofs, clearing debris, etc.

Why P-C Insurance ClaimsOften Rise Faster than Inflation (cont’d)

5. for example, they mightd. Be confident that they car raise prices without fear

of a drop in demand for their services If your property is damaged you generally must get it

repaired or replaced

e. Be affected by shortages of particular skilled labor despite general conditions of high unemployment

If might be difficult to find and keep mechanics with the training and experience to fix today’s complex modern cars

f. Be affected by the cost of acquiring expensive new diagnostic equipment and the “need” to use it (and charge for its use) perhaps more often than necessary

56

6. Demand Surge. In catastrophe (and some other) situations, demand for materials and labor is highly concentrated, pushing up prices for scarce resources.

7. Cost-shiftinga. The “deep pocket” principle: as long as an

insurer “can afford it,” some Courts will extend their liability (judicial cost inflation)

b. Medical care providers charge higher rates for patients not covered by Medicare or Medicaid

Why P-C Insurance ClaimsOften Rise Faster than Inflation (cont’d)

P/C Premium Growth and Inflation

57

Mainly Driven by the Industry’s Underwriting Cycle,

Not the Economy

58

-5%

0%

5%

10%

15%

20%

25%

71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

CPI-U NPW Growth

P-C NWP Growth Generally Matchesor Exceeds Inflation 1971-2009

(Percent)1975-78 1984-87 2000-03

Shaded areas denote “hard market” periodsSources: A.M. Best, ISO, Insurance Information Institute

59

Underwriting and Inflation

60

Other Underwriting-RelatedEffects of Higher Inflation

Rising Insurable ValuesPremium volume and agent commissions will rise even if rates

are flat

Increased Political Response to Rate Increase RequestsRegulators might reject rate increase proposals to curry favor

with insurance consumers

Lower Profits Due to Reserve Strengthening

Burn Through on RetentionsRetentions, deductibles burned through more quickly

Reinsurance Penetration/ExhaustionHigher costs risks burn through their retentions more quickly,

tapping into reinsurance more quickly and potentially exhausting their reinsurance more quickly

An Inflation Spike Would be More Costly for“Long-tail” than “Short-tail” Insurance Lines

Short tail LoBs (mainly property insurance) can quickly adjust to an increase in the rate of inflation

–Policy periods generally last six months to a year, or may be on a reporting form, so they adjust premiums frequently

–Claims tend to be paid soon after they’re reported, so an inflation spike won’t affect them as much

–Their asset durations match their liability structure, so investment income may increase rapidly with interest rates

An Inflation Spike Would be More Costly for“Long-tail” than “Short-tail” Insurance Lines

Long tail LoBs have more difficulty with resurgent inflation

–Claims tend to be paid long after they’re reported, so an inflation spike would magnify claims

–Their asset durations match their liability structure, so investment income may increase gradually, while values of existing assets would decline with an inflation spike

–Needed reserve strengthening would sap profits, making it difficult to earn their equity cost of capital

Investments and Inflation

63

Interest-Based InvestmentsBenefit from Higher Inflation

64

Distribution of P/C InsuranceIndustry’s Invested Assets

Sources: NAIC, via SNL Financial; Insurance Information Institute calculations.

Invested assets totaled $1.245 trillion as of 9/30/09

Insurers are generally conservatively invested, with more than 2/3 of assets invested in bonds as of 9/30/09

Only about 17% of assets were invested in common and preferred stock as of 9/30/09

Even the most conservative of portfolios was hit hard in 2008

Portfolio Facts

7.3%17.0%

1.2%

5.7%

68.7%

Bonds

StockMortgages & Real Estate

As of September 30, 2009

Cash and Short-term

Investments

Other

Bond Yields Tend to Follow Inflation,but the Relationship is a Loose One

-2%

0%

2%

4%

6%

8%

10%

90

91

92

93

94

95

96

97

98

99 00

01

02

03

04

05

06

07

08

09

10F

11F

12F

13F

14F

CPI-U % Change U.S. Treasury 10-Year Note Yield

Sources: US Bureau of Labor Statistics (history); Blue Chip Economic Indicators, 10/09 and 2/10 issues (forecast)

Forecast

2%

3%

4%

5%

6%

7%

8%

9%

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

10F

11F

12F

13F

14F

P-C Inv Income/Inv Assets 10-Year Treasury Note

P/C Investment Income* as a % ofInvested Assets Follows 10-Year U.S. T-Note

*Not including realized capital gains/lossesSources: history: Board of Governors, Federal Reserve System; A.M.Best; Insurance Information Institute.forecasts: Blue Chip Economic Indicators, 10/2009 issue

P-C investment yield historically tracks 10-year Treasury note quite closely

The midpoint of the Blue Chip forecasts indicates that T-note

yields might spike in 2012.

Inflation’s Effect onP-C Claim Reserves

67

Will Impairments RiseIf Reserves Are Deficient?

68

$2.3

-$2.1

-$8.3

-$2.6-$6.6

-$9.9-$9.8

-$4.1

$1.0

$11.7

$23.2

$13.7$9.9

$7.3

-$6.7-$9.5

-$14.6-$16.0-$15.0

-$5.0

-$20

-$15

-$10

-$5

$0

$5

$10

$15

$20

$25

$3092

93

94

95

96

97

98

99

00

01

02

03

04

05

06

07

08

09

10F

11F

Pri

or

Yr.

Reserv

e R

ele

ase ($B

)

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

Infla

tion

(CP

I-U)

Prior Yr. ReserveDevelopment ($B)Inflation

Strengthening and Releasing P/C Reserves Appears Unrelated to Inflation

Reserve Releases Are Expected to Taper Off in 2010 and Drop Significantly in 2011

Note: 2005 reserve development excludes a $6 billion loss portfolio transfer between American Re and Munich Re. Including this transaction, total prior year adverse development in 2005 was $7 billion. The data from 2000 and subsequent years excludes development from financial guaranty and mortgage insurance. Sources: Barclay’s Capital; A.M. Best, BLS

69

Reasons for US P/C Insurer Impairments, 1969–2008

3.7%4.2%

9.1%

7.0%

7.9%

7.6%

8.1% 14.3%

38.1%

Source: A.M. Best: 1969-2008 Impairment Review, Special Report, Apr. 6, 2008

Deficient Loss Reserves and Inadequate Pricing Are the Leading Cause of Insurer Impairments, Underscoring the Importance of Discipline.

Investment Catastrophe Losses Play a Much Smaller Role

Deficient Loss Reserves/Inadequate Pricing

Reinsurance Failure

Rapid GrowthAlleged Fraud

Catastrophe Losses

Affiliate Impairment

Investment Problems

Misc.

Sig. Change in Business

P/C Insurer Impairments, 1969–2009p8

15

12

71

19

34

91

31

21

99

16

14

13

36

49

31 3

45

04

85

56

05

84

12

91

61

23

11

8 19

49 50

47

35

18

14 15

71

1

5

0

10

20

30

40

50

60

70

69

70

71

72

73

74

75

76

77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

98

99

00

01

02

03

04

05

06

07

08

09

p

Source: A.M. Best; Insurance Information Institute.

The Number of Impairments Varies Significantly Over the P/C Insurance Cycle, With Peaks Occurring Well into Hard Markets

5 of the 11 are Florida companies (1 of these

5 is a title insurer)

71

P/C Insurer Impairment Frequencyvs. Inflation, 1970-2009p

-2%

0%

2%

4%

6%

8%

10%

12%

14%70

71

72

73

74

75

76

77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

98

99

00

01

02

03

04

05

06

07

08

09

Inflatio

n (C

PI)

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

Imp

airm

en

t Rate

Inflation P/C Impairment Frequency

0.36% 2009 impairment rate is III estimate based on preliminary A.M. Best data.Sources: BLS, A.M. Best, Insurance Information Institute

The Highest Impairment Rates Appear Affected by Inflation,But the Correlation Isn’t a Strong One

What Can Insurers Do?

72

Re-Ignited Inflation is An Economic Catastrophe (Like a Major Hurricane?)

Hold more capital to cover the uncertainty of re-emergent inflation

Go more heavily into inflation-indexed investments

Improve the quality of data used for reservingUnderlying trends & elasticitiesTailored inflation indexes?

Regulators Must Be Part of the Discussion

www.iii.org

Thank you for your timeand your attention!

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